If you’re preparing for an Oxbridge Economics interview, you might not be sure what to expect. Sure, you’ve heard that the tutors will challenge you and push your understanding, but what does that actually mean?
To give you a feel for a model economics interview, here are three worked through interview questions, complete with annotations and explanations. And if you’re getting ready for interviews, why not also look at our complete guide to preparing for an Oxbridge Economics interview?
In the UK, the target rate of inflation is 2%. Why isn’t it 0%, or 4%?
Student: I’m going to approach this question in two parts, if that’s okay. I’m going to consider why the inflation target isn’t higher than it is, and then why it isn’t any lower.
Interviewer: That seems to me like a very sensible approach. Continue.
Student: So, why not target a rate of inflation in excess of 2%? Well…one reason is that as prices rise, people’s incomes, provided that they’re fixed, fall. Many of the people who received fixed incomes, like pensioners or cleaners, are vulnerable. They would really suffer under rapid inflation.
Interviewer: That’s true. Who else loses out under a high inflation rate?
Student: People who have savings.
Student: Any savings held would buy less. Suppose that I put £100 in a bank account today and want to withdraw it tomorrow-say, in order to buy cheese. The price of a wheel of cheese today is £10. So I can buy 10 wheels of cheese today. Overnight, inflation, at a rate of 100%, is experienced. A wheel of cheese now costs £20. I can only afford 5 of them. So I’m worse off.
Top Tip: Numerical examples are generally helpful because they demonstrate mathematical competence.
Interviewer: And who gains from inflation?
Student: Mostly those who are in debt. If I have taken out a mortgage on a house, of, say, £1,000,000, then as prices rise I in effect owe less. If annual inflation is 100%, then £1 at the beginning of the year will be worth 50p at the end of the year. So my mortgage will essentially have fallen to £500,000.
Interviewer: Right. And why might we not want to redistribute wealth from savers to borrowers?
Student: I guess because it disincentivises saving. And this is worrying, because what households save becomes investment, since banks and building societies lend to firms. The accumulation of capital is probably the engine of economic growth, so we want to encourage as much investment and savings as possible for the sake of the future.
Interviewer: And what about the reasons for avoiding inflation below 2%?
Student: Hang on, that wasn’t the question. The question was about why the target rate of inflation shouldn’t be below 2%, not why the actual rate of inflation shouldn’t be 2%!
Interviewer: And what is the importance of this distinction?
Student: Well, in the UK, inflation is measured using the Consumer Price Index…
Interviewer: Could you explain in a sentence or two what the CPI is? Apologies for interrupting.
Student: Basically a survey of what households goods and services households buy and how much of their income they spend on them is undertaken. This is used to construct a basket of the most commonly consumed items. A second survey records their prices. From these a weighted price index is created.
Interviewer: Carry on now.
Student: The weights are fixed for a year, which means that there is a substitution bias. Prices don’t rise evenly. If the price of bananas is rising much faster than the price of apples, for instance, then consumers will buy fewer bananas and more apples. But this behavioural response isn’t taken into account in the CPI. So it tends to overstate inflation. Which means that if our inflation target is a rate of 2% as measured by the CPI, then we’re really experience a rate of inflation more like 1%.
Interviewer: Excellent. Suppose, as in your example, that the CPI exaggerates the inflation rate by exactly 1%. Then why don’t we want the CPI to be 1%, so that inflation is 0%?
Student: Well, inflation is reported to ‘grease the wheels’ of the labour market.
Interviewer: What does this mean?
Student: Wages tend to be sticky in the downwards direction. Which means that if there is a negative shock to the demand for labour, then wages can’t fall to equilibrate the labour market. This creates more unemployment than there would be otherwise. This can be avoided, however, at least to some extent, if there is inflation, for then real wages are falling unless there are nominal increases.
Interviewer: Nice. Why else?
Student: Um…Oh! The deflation trap!
Interviewer: Could you explain?
Student: If the nominal interest rate is at its zero lower bound, then the real interest rate must be rising each period provided that the inflation rate is negative and falling each period. This is a major problem, because during a recession output is brought back up to potential by lowering the real interest rate, which stimulates both consumption and investment. Any increase in the real interest rate, then, makes the recession worse. And this then causes the inflation rate to fall further, etc.
Interviewer: Great. Very quickly, before your interview ends, could you tell me how the real and nominal interest rates are related?
Student: Yep. This is given by the Fisher equation, which states that the nominal interest rate is just the real interest rate plus the inflation rate.
As a way of ‘buying time’ to think when first asked the question, you might like to offer a definition of inflation and then reason from there.
The student answering the question saw straight away that an effective approach would be to consider why the inflation target isn’t raised and isn’t lowered separately. The interviewer might suggest doing this for another student who was less sure of how best to answer the question.
What’s the question testing?
This question is testing your knowledge of inflation and your ability to relate this to policy.
Extending the question:
You might be asked why inflation rather than the money supply is targeted. Try and come up with a diagram depicting the market for money and what happens in it when there are shocks to support your answer.
Related topics from university:
Many topics are related, e.g. monetary policy within the IS-PC-MR/AS-AD model.
Would you advise the UK government to tax beef?
Student: I would. I think it’s fair to say that the production of meat products such as beef contributes to climate change. Cattle have a particularly destructive impact on our environment. Not only are forests cleared for them in countries such as Brazil, but they release methane as they digest their fodder, which is an even more worrying ‘greenhouse gas’ than carbon dioxide.
Interviewer: That does seem to be the scientific consensus. How does it relate to the decision of whether or not beef ought to be taxed, though?
Student: Well, prices have an allocative function. In each market, an equilibrium price prevails as a result of the interaction of buyers and sellers, such that no-one wants any more or any less of the good than they end up with. This means that valuation of the buyer of the last unit sold is one and the same as the seller’s valuation. So the marginal benefit equals the marginal cost.
These marginal costs and benefits are private-they’re those of the individuals involved. But usually they’re also society’s. They only aren’t if an externality is present. Where an externality is present, the market fails, in the sense that it either results in too much or too little of the good being produced, from the point of view of society.
Interviewer: Good. But you haven’t told me what an externality is.
Student: Sorry! An externality is just a benefit or cost experienced by a third party. So in the case of producing beef, the release of methane is an external cost, as is the deforestation involved.
Interviewer: What would an example of a very different sort of externality, a positive one arising from consumption, be?
Student: The enjoyment passers-by get from a house decorated with lights at Christmas.
Interviewer: So why, in the case of beef, would a tax correct the market failure?
Student: Would this be a tax like VAT, paid by those who buy beef? Or would it be paid by firms who produce and package beef?
Interviewer: Does it matter?
Student: I guess not. Because all that matters is the effective incidence, as opposed to the actual incidence. If firms are required to pay either a per-unit tax or a lump-sum tax for producing beef, then they’d just pass along this increase in costs to consumers in the form of higher prices. And if consumers are faced with a tax on beef, then firms will have to lower their profit margin, at least by a little, so that the price of beef doesn’t rise about the amount that people are willing to pay.
Interviewer: That’s right. The burden of an indirect tax is shared by the consumer and the producer. But what determines how large the share of the burden each faces is?
Student: The relative prices elasticities.
Interviewer: Could you define these for me and then elaborate?
Student: Sure. The price elasticity of demand is the percentage change in the quantity demanded of a good divided by the percentage change in its price. And the price elasticity of supply is similar, but with supply instead of demand. The more price elastic demand is relative to supply, the less consumers will shoulder of any sort of sales tax, and vice versa.
Interviewer: So going back to the question…
Student: Yes! A tax on beef raises its price, which in effect internalises the externality, or externalities, present.
Interviewer: How so?
Student: Well now at the new price, anyone who buys beef is paying not only the cost to the producer of fattening and slaughtering cows, but also the cost to society of the negative impact on the planet of these activities. So in deciding how much beef to consume, people are considering the whole cost of encouraging more cattle to be farmed.
Interviewer: Could you draw me a diagram of the market for beef, illustrating what happens to the equilibrium price and output after a tax is put in place?
Student: Ad valorem or specific?
Interviewer: Specific please.
Student: Draws a diagram.
Interviewer: Tell me, how do the government’s economists work out what the optimal tax on beef is?
Student: Well…their estimate makes use of data about how damaging producing beef is. They also need to estimate the price elasticities and the demand and supply equations for beef.
- Does the price of beef reflect how valuable beef is to society?
- What would imposing a tax do to the quantity of beef supplied and demanded?
- Why would we want less beef to be eaten that we are currently eating?
What’s the question testing?
This is assessing the student’s understanding of the basic supply and demand model, either from their intuition or formal studies.
Extending the question:
- What would be the effect of a tax on beef on the market for lamb, and what would the implications of this be for the UK? (Hint: beef and leather are complements, and a lot of sheep are farmed in the North of England.)
- What would the effect of a tax on beef be on the market for leather? (Hint: beef and leather are co-products.)
- If we should tax beef, should we tax other unhealthy products, like ice-cream?
Related topics from university:
In your first term at Oxford, you’ll have lectures in microeconomics, and probably tutorials, as well, depending on which college you’re at. You’ll start by covering methodology and then move on to willingness-to-pay (i.e. demand) and willingness-to-accept (i.e. supply). You will then learn about taxes and subsidies. All of this is quite mathematical, in that you will be expected to differentiate demand and supply functions and calculate the deadweight loss of certain policy interventions etc.
(Note: the interviewer is asking this question with the intention of getting the student to derive a mathematical expression for the change in output and price charged by a pair of firms after they merge to test their calculus. This is an especially tricky question – I suspect that I would have been rather stuck had I been asked it – and is likely to be asked only to candidates who have studied further maths at A-level.)
Should a merger between rival firms be prevented from happening?
Student: Only under certain circumstances.
Interviewer: And what might these be?
Student: When banning the proposed merger would be better than allowing it to go ahead, in terms of maximising welfare.
Interviewer: Would this usually be the case?
Student: Because after merging, the market becomes more monopolistic. So the resulting entity can get away with raising its price by restricting its output.
Interviewer: Consider the case of a duopoly. Do you know what the term ‘duopoly’ means?
Student: I do. A duopoly is a concentrated form of market structure in which there are just two firms competing.
Interviewer: Exactly. Call the firms ‘1’ and ‘2’. 1 and 2 produce homogenous goods, say, hydrochloric acid for use in laboratory experiments. 1 produces q1 litres of hydrochloric acid and 2 produces q2 litres, which makes total supply, Q, q1+q2. Demand for hydrochloric acid depends on price alone, making the linear inverse demand function P(Q)=a-bQ. 1 and 2 use the same production technology, meaning they have the same constant marginal cost, c. The firms compete on quantities, with neither firm acting as a leader or a follower. Given all this information, could you derive an expression for each firm’s price and output prior to their merger?
Student: Gosh…I suppose I can. But I’m not sure where to start, to be honest.
Interviewer: That’s okay. How about considering each firm’s objective?
Student: Each firms wants to maximise its profit. Which suggests that I’m going to need to do some differentiation. But I don’t know what I need to differentiate….oh, a function giving the firm’s profit!
Interviewer: Good. What determines a firm’s profit?
Student: Its revenue less its costs. I know the firm’s revenue function. This is just price multiplied by output. So firm 1’s revenue is…
Interviewer: I’m going to suggest that you solve the profit maximisation problem you’re tackling here for an arbitrary firm i rather than for both firm 1 and firm 2, because they’re identical, and that you refer to the other firm as j.
Student: Okay, thanks, I’ll do that. So firm i’s revenue is Pqi.
Interviewer: True, but remember that you’ve got an inverse demand function.
Student: Yes. So firm i’s revenue function is qi(a-bqi-bqj), since P=a-bqi-bqj. Now to get its profit function I need to subtract its cost function from this…which is cqi, because you’ve told me that its marginal cost is c.
Interviewer: Very good.
Student: So I want to find the maximum point of the function qi(a-bqi-bqj)-cqi.
Interviewer: Yes, you do. How do you do this?
Student: I differentiate it with respect to qi.
Interviewer: Use the pen and paper if you like.
Student: Right…so the derivative I’ve found is this, a-2bqi-bqj-c. Which I want to set to zero. I’m a bit stuck now though. How does this help me work out the price and output of firms 1 and 2?
Interviewer: Well firm i will be choosing its output such that qi=(a-c-bqj)/2. This is just the equation you gave me, rearranged. And firm j’s output is optimised where qj=(a-c-bqi)/2, by symmetry. So you now have simultaneous equations to solve.
Student: Okay…so qi=qj=(q-c)/3b and P=a-b[2(a-c)/3b].
Interviewer: Fantastic! That was the tricky bit. Now for the easy bit. If the firms now merge, what will the price of their product be, and how much of it will be produced?
Student: Well now there is just one firm, which is a monopoly.
Interviewer: Yes. What is the monopoly trying to do?
Student: Maximise its profit.
Student: So the monopoly wants to find the maximum point of the function (a-bQ)Q-cQ.
Interviewer: Which is where…
Interviewer: So how much is each component of the monopoly producing?
Student: Half this. So (a-c)/4b.
Interviewer: And what will the price be?
Student: Um…the level of output makes the price a-b[(a-c)/2b].
Interviewer: So what can we conclude about the impact of the merger?
Student: Well it will unequivocally make consumers worse off. They’re now paying a higher price and enjoying less of the product.
Interviewer: Precisely, well done. Now can mentioned that there might be exceptional cases where a merger doesn’t have this impact. Can you say a bit more about what these might be?
Student: Sure. One exceptional case would be where one of the firms involved in the merger is much more efficient than the other. So post-merger, costs of production fall. This makes it likely that the price charged to consumers will fall as well and that output will be stepped up.
Interviewer: And are there any other circumstances under which a merger might benefit consumers?
Student: I don’t think so, no.
Interviewer: Well what about if firm 1 makes engines for cars and firm 2 makes car bodies? And each of these firms is a monopoly?
Student: Ah…here the merger is a vertical one, rather than a horizontal one. I think this would be similar to the efficiency case. Costs will fall as will the price of cars.
Student: Because now the firm making car engines isn’t selling these at a price involving a monopolistic mark-up to the firm that makes the bodies of the cars. So the consumer no longer faces a double mark-up.
This is a tricky technical question. But it needn’t be. For students who don’t have a mathematical background, more help would be given with the derivation.
What‘s the question testing?
It is important for economists to also be good mathematicians. A lot of the economics course at Oxford relies on students being able to do linear algebra and calculus. For students who haven’t done maths A-level, classes are held in Michaelmas term to complement the micro lectures.
This question is testing the student’s skills at maths, in relation to an important area of micro, industrial organisation.
Extending the question:
- Is there an optimal number of firms to have in a market? (Hint: think about the long term impact on quality.)
- In the duopoly case, how would the impact of the merger differ if the firms in it compete on price, not quantity?
- In the duopoly case, what would happen if firm 1 sets its output, and, after observing this, firm 2 then sets its output?
Related topics from university:
The maths done in the question is similar to that expected in answering a question on duopoly from a problem sheet or prelims exam paper.
Different models of duopoly are covered at prelims level: Cournot, Bertrand, and Stackelberg. If you’re interested in finding out more, I recommend reading the Wikipedia entry on each of these.
Hopefully, these example interviews will give you an idea of what to expect! Remember: stay calm, and explain your thinking, and you’ll be able to stand out.